Pension tax relief is likely to be in the firing line in next week’s Budget says Royal London director of policy Steve Webb. He sets out the Chancellor’s main options, and his assessment of the likelihood of each of them happening

With pressure to spend more, especially on young people, and with revenue shortfalls from a stuttering economy, a politically weakened Chancellor is likely to turn again to tax relief as a source of less politically challenging revenue raising. The annual allowance remains the most likely source of cuts, especially with the increase in the Isa limit, but other aspects of the system may not escape scrutiny.

The latest HMRC figures suggest that the cost of pension tax relief rose by around £3bn in the last year for which figures are available. In addition, the cost of not charging National Insurance Contributions on employer pension contributions rose by a further £2bn. Since 2010, successive Chancellors have cut the various limits for pension tax relief on an almost annual basis, and the present Chancellor is likely to have taken a very detailed look at how much more can be saved on this major item of public spending.

1. The Annual Allowance

With contribution limits on Isas having been raised substantially in recent years to £20,000, the Chancellor will feel he can cut the annual allowance with very limited political fallout. The most recent cut in the general level of the annual allowance was in 2014/15, down from £50,000, and that change – combined with a linked reduction in the lifetime allowance – is estimated to raise around £1.1 billion in 2017/18.

One little-noticed reason why Annual Allowance reductions are now more likely is the major reform of public sector pensions. In the past, public sector pensions were based around an individual’s final salary. Public service pensions are now based on a career average basis which means that promotions do not create the same surge in pension rights. The Government may conclude that they can now justify a much lower Annual Allowance.

Possible changes: One or more cuts to the annual allowance, perhaps to £35,000 and then to £30,000

Likelihood: 8/10

2. The Annual Allowance for high earners (AKA the ‘tapered annual Allowance’)

From 2016/17 the Government made a further reduction in the Annual Allowance, this time focused on high earners. The rules are complex, but the change mainly applies to those with total taxable income, including the value of any employer pension contributions, above £150,000 per year. For every £1 of income above this threshold, the Annual Allowance is ‘tapered’ down by 50p until it reaches a floor of £10,000 at incomes of £210,000 or more. When fully implemented – that is, when the ability to carry forward unused annual allowances from earlier years is exhausted – this measure is expected to raise over £1bn per year.

It seems likely that the Chancellor will be looking to revisit this measure to see if extra revenue can be found. This could be by reducing the £150,000 threshold and/or increasing the taper rate. From the Chancellor’s point of view, the attraction is that this is a complex area which will affect relatively few voters but which could raise significant amounts.

Possible changes: A cut in the £150,000 threshold to £125,000.

Likelihood: 8/10

3. The ‘Lifetime Allowance’

In 2010 the limit stood at £1.8 million, but this was cut to £1.5 million in 2012, £1.25 million in 2014 and £1 million in 2016. Each of these changes was accompanied by a complex system of transitional arrangements. As this is an area where Chancellors have repeatedly sought revenue, there must be a chance that we will see further cuts to the LTA.

Possible changes: A cut in the Lifetime Allowance to £900,000

Likelihood: 6/10

4. Detailed rule changes

One attraction to the Chancellor of changing the detailed rules around pension tax relief is that the system is not widely understood by the general public and the political impact of changes is therefore much reduced. There are some particular areas where savings might be found. These include a reduction in the ability to ‘carry forward’ unused allowance from earlier years: at present, individuals can carry forward up to three years’ worth of unused annual allowances; this means that whenever there is a change to the annual allowance the revenue takes time to come through as people simply carry forward unused allowances from earlier years to make up the shortfall;

Likelihood 5/10

5. Further reduction in the Money Purchase Annual Allowance

Introduced to discourage ‘recycling’ where individuals put money into a pension to benefit from tax relief and a tax free lump sum on withdrawal before putting the money back in again, the limit started at £10,000 per year but the Chancellor used his first Autumn Statement to cut this limit to £4,000 from April 2017. The Election interrupted the necessary legislation, which is only now being put into effect. A further cut is possible, though the original cut only raised £70m per year, which is a relatively modest sum in terms of tax revenue; a further cut cannot however be ruled out.

Likelihood 3/10;

6. Apply National Insurance to employer pension contributions

When an employer pays a wage to an employee, the firm is liable for a NICs rate of 13.8 per cent, but if that money is paid into a pension there is no National Insurance to be paid. HMRC estimates that that the cost to the Exchequer of not levying employer NICs on employer pension contributions was £15.7 billion in 2015/16, an increase of £2 billion on a year earlier.

Whilst charging full NICs on employer contributions would be a huge change, a ‘special’ new rate could be introduced and could be a significant revenue raiser.

Possible changes: A new 1 per cent rate of NICs on employer pension contributions, raising around £1bn per year

Likelihood: 5/1

And finally…something not likely to change

At Budget times there is always speculation about the future of the ‘tax free lump sum’. However, a politically weak Chancellor would find it incredibly difficult to remove this benefit which is one of the few elements of the pension tax relief system which is reasonably widely understood and valued. He could, in principle, announce that new money going into pensions would no longer attract a tax free lump sum, but this would raise little revenue in the short-term and would stoke up alarm that existing tax-free lump sums could be under threat. Even if action on tax-free cash was taken in the Budget it is hard to believe any significant change would command a majority in the House of Commons once the impact on savers became apparent.